Comment: Blame Lax Management, Not Derivatives

Just when it seems the shackles on financial services are going to be loosened with the repeal of the Glass-Steagall Act, a wave of negative publicity threatens to unleash new regulatory restrictions on derivatives.

Nothing could be more misguided.

It's time to stop castigating derivatives. It's time to stand up and defend them for their contributions to the stability of the economy, instead of misrepresenting them as "exotic" agents of financial ruin.

Today, derivatives are being blamed for singlehandedly bringing down Barings PLC and Kidder, Peabody & Co., two venerable financial institutions, through high-stakes gambles by Nick Leeson and Joseph Jett.

To me, the real crimes were their efforts to disguise their losses while increasing their loss exposure with additional gambles. This was compounded by managements suffering from myopia or paralysis. Maybe these managements concluded that big returns were being generated without any risk. Or maybe they just couldn't take charge of a deteriorating situation.

Are derivatives the root cause of the problem - or are the flawed characters of the principal players to blame? Is it the thousands of contracts traded daily, or lack of internal controls - or just a general breakdown in management oversight?

Surely, the financial instrument is not at fault, as recent history has shown.

Six years ago, a chorus of critics alleged that junk bonds were responsible for the demise of Drexel Burnham Lambert Inc. and the virtual undoing of much of corporate America, which in turn led to massive management layoffs.

In fact, Drexel Burnham went bust as the result of rogue dealings by a few individuals, not because of high-yield instruments.

These instruments have been somewhat redeemed by recent events. Many of the small companies they financed in the 1980s have become fierce competitors, large employers, and developers of important new products.

The competitive spirit fostered in part by junk bonds has caused American industry to wake up and cut the excessive fat. Industry is becoming more productive and stable. New products have enhanced our lives and added hundreds of thousands to the employment rolls in exciting industries such as broadcasting, cellular communications, and media.

Junk bonds have become a mainstay of the American capital infrastructure.

It is easy to assign blame to a financial instrument, be it derivatives or a junk bond, but it is not very sensible. In fact, most of the rhetoric about derivatives stems from misunderstanding.

Many people do not appreciate that derivatives have been around for a century or more.

One of their first uses in this country was by farmers who were seeking to assure a certain return on their crop long before it was harvested. On the other side of the transaction would be a grain broker, or perhaps a baker seeking to lock in a steady supply at a stable price.

Derivatives enabled both parties to plan for the future and grow - to control their business risks while employing more people.

In more recent years, most users of derivatives have been corporations operating in a global marketplace that are seeking some stability for their foreign-currency transactions. These transactions are entered into by officers at the highest levels of the corporation - executives with a great deal of experience and education, not to mention savvy.

What is needed is not more regulation but stronger oversight by directors and corporate management, to ensure that proper controls are in place.

The old maxim is "The higher the risk, the greater the rewards." Certainly that is true with derivatives, as with any sophisticated financial instrument.

With so great a reward to be had, is it too much to expect management to entrust this responsibility to people with the highest integrity? Is it too much to expect managers to focus on nuts-and-bolts controls and reviews, to investigate fully the origins of significant profits, and not to just shut their eyes until there are major losses? I think not.

Don't blame derivatives. What we have seen recently in the Barings and Kidder Peabody situations is management failure to spend enough time to understand what is going on - to understand the origins of significant trading profits before they become losses.

The problem is not with the financial instruments whose origins date back more than a century, to farmers in the market.

Mr. Sullivan, a former asset manager for Revlon Corp. and Kidder, Peabody & Co., is president of Sullivan & Co., New York, an executive search firm.

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